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Why Use Butterflies?

Filed Under Trading Articles 

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The Butterfly’s primary objective is premium collection. The Butterfly is a premium collection strategy (much like the Straddle and Strangle) except for a significant difference. The difference is that the Butterfly is a hedged premium collection strategy.

That is what separates it from most of the other premium collection strategies.

Because the Butterfly is a hedged premium collection strategy, it has a fixed loss profile and is not as aggressive or risky of a premium collection strategy like the Straddle or the Strangle. However, as with any investment, if you take less risk you must get less reward.

The Butterfly’s primary goal is premium collection, which comes through the sale of the center strike options. However, in order to hedge, you must somewhere and somehow give up a little something. That something is going to be a portion of the total potential premium collected. In other words, we will use a portion of the premium we collect from selling the center strikes to buy the outer strikes. These outer strikes protect us from losses at the expense of reducing our potential profit.

The Butterfly is not going to be as big of a moneymaker as a Straddle or Strangle, but it will not expose you to as much loss. The following charts show the profit and loss profile for the long Butterfly:

For any profit and loss diagram, the “bends” in the chart always occur at a strike price. For the long Butterfly, points A and C represent the long strikes.

Point B is the short position located at the center strike. By looking at the profit and loss diagram for the long Butterfly, you can see that the trader wants the stock price to stay still at the center strike (point B) since that is the point of maximum profit. As the stock moves to the right or left from the center peak, profits reduce until the position breaks even. If the stock price moves beyond the break-evens, the ensuing loss will only last for a little while before the graph flattens out at strikes A and C and the red line heads sideways.

That is why the arrows point sideways. Now you can clearly see the reason for buying the outer strikes A and C; they hedge us against unlimited losses. This means that once the stock price moves beyond a certain point either up or down, your losses stop accruing. Any further stock price movement in that direction will incur no further dollar loss.

Now let’s take a look at the profit and loss diagram for the short Butterfly:

This profit and loss diagram tells a different story. While the long Butterfly trader wants the stock to stay at the center strike, the short Butterfly trader wants the stock price to move far away from the center strike. This should make intuitive sense because we said earlier that the short Butterfly trader is simply taking the opposite side of the long Butterfly trader. This means that the profits to the long Butterfly trader are exactly the losses to the short Butterfly trader and vice versa.

We know to classify the Butterfly as a premium collection strategy with risk protection. We know how the Butterfly is constructed. It is either all calls or all puts with three equidistant strikes in a 1-2-1 format. Now let’s dive deeper and see how it works.

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